RBA can no longer rely on Fed policy to keep the $A down

The better than feared March quarter consumer price index (CPI) report should undercut concerns that local interest rates are likely to rise any time soon. And it raises the question of why the Australian dollar remains uncomfortably high.

Indeed, it’s fair to say the strength in the Australian dollar so far this year has surprised investors and central bankers alike.

The story seemed pretty clear – with commodity prices falling and monetary conditions in the United States tightening up, the $A was supposed to keep falling.

The $A had dropped from a recent peak of around $US1.04 in April last year, reaching a low of US86.7¢ by late January. Growing expectations that the US Federal Reserve would begin tapering its money-printing program were eventually realised, with the Fed cutting back on stimulus at both its December and January policy meetings.

The Fed is still widely expected to reduce its bond buying (and associated money-printing) scheme over the rest of this year.

Our own Reserve Bank of Australia seemed to think the Fed’s actions would single-handedly keep the $A falling, but this has now shown to be completely wrong.

Since late January, the $A has rebounded – hitting a recent high of just over US94¢. It has also broken above its 200-day moving average, considered a key technical indicator of medium-term trend direction.

Reasons for the rebound

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Why the rebound? When asked last week, a senior RBA official conceded he had no idea why.

But I’ve got a few ideas. For starters (as is the way with financial markets), when something is widely expected to happen, chances are the financial implications of this are already priced into the markets, and they don’t then move in ways that most expect.

Late last year, for example, while agreeing with the majority that the Australian dollar should likely keep falling, I also noted the expectation the US Fed would soon begin reducing its monetary stimulus program – which in turn should push up the US dollar – was already widely shared. As a result, there was a risk the $US might not fall as quickly as many expected, and the $A could remain uncomfortably high.

Of course, it didn’t help that a particularly harsh winter caused the US economy to slow for a time – leading to brief speculation the Fed would pause its tapering program. The US economy has since improved, but newly installed Fed chair
Janet Yellen
has quickly undercut the otherwise bullish US dollar outlook by reminding everyone that the US’s key policy interest rates are likely to remain very close to zero for at least a year longer.

The Fed’s continued dovish interest rate outlook is partly a reaction to fears that, otherwise, the US dollar could rise too far too fast – threatening America’s still fledging economic recovery. Indeed, both the European Central Bank and the Bank of Japan are still maintaining aggressive monetary stimulus programs, and are doing their utmost to jawbone their own currencies downward for the sake of their exporters.

As a result, to my mind the key driver of the $A in recent months has been domestic rather than international factors.

The Australian economy has marginally improved since late last year, and after a brief scare with a higher than expected consumer inflation in the December quarter, the Reserve Bank of Australia moved from an easing to “neutral" interest rate policy bias. And, prematurely in my view, the RBA also ended its “jawboning" policy of trying to talk down the Australian dollar.

Don’t blame it on the greenback

While we can often blame $A movements on trends in the US dollar, we can’t blame the greenback this time around. Indeed, the $A has lifted by 7.4 per cent against the $US since late January, but also by 6 per cent against the euro and Japanese yen. The US dollar index has fallen, but only by 0.8 per cent since the $A started rising.

The global perception that our central bank is less anxious to keep its currency cheap and competitive – as distinct from many others in the ongoing global “currency war" – has encouraged traders to keep buying it up, as it still offers good yield advantages over the effectively free-to-borrow US dollar, euro and Japanese yen.

So I have news for the RBA: the Fed’s tapering program has already been priced in by the market and it doesn’t seem enough to keep the $A heading lower, especially when most other central banks are actively doing battle in the global currency war to keep their own exchange rates more competitive.

If the RBA truly wants a cheaper $A – as it should – it needs to re-instigate its jawboning and threaten lower interest rates if the $A remains uncomfortably high.

As for fears this could stoke a house-price bubble, a sober analysis of the housing market suggests only Sydney and Melbourne are running hot, which could reflect the growing role of self-managed super funds and foreign investors as much as low interest rates.

I also suspect already-pressing affordability constraints will soon start to cool these markets in any case.